The history of modern finance is sprinkled with periods of market upheaval (such as the implosion of the European Monetary System in 1992 or the 1997 Asian currency crisis) but as long as the effects were more or less contained, many observers were willing to accept uncertainty as the cost of ensuring greater global access to capital. However, the severity of the two most recent crises in 2008 and 2011â€“2012 undermined this complacency (Engelen et al. 2011), causing widespread concern about the extent to which the international capital markets remain fit for purposeâ€”or whether they have become dysfunctional. An increasing number of observers, even ones broadly in favour of free market globalization (Bhagwati 2007), have arrived at the latter conclusion. The case for an at least partial re-regulation of global finance has become mainstream.
To understand the new consensus, it is worth reviewing the causes of the two recent crises. The 2008 subprime crisis was rooted in the availability of cheap credit in the USA during the early 2000; a time when American lenders awarded huge mortgages to property developers and households without controlling their ability to repay. Unsurprisingly, defaults began accumulating, forcing several major US financial institutions to borrow increasing amounts of capital to restore their balance sheets. This led in turn to rumours about their financial health; panic spread; and institutions sitting on surplus funds became much less willing to lend them. The ensuing â€˜credit crunchâ€™ affected other banks whose relative lack of depositor funds meant that they relied excessively on interbank funding. By mid-2008, a full-blown crisis had erupted, culminating in the disappearance of powerful investment banks such as Lehman Brothers and Bear Stearns.
On the face of things, the problem was purely American in origin. Yet it ended up having a global impact, demonstrating the coupling between different national capital marketsâ€”or, as the expression goes, how everyone catches a cold when Washington sneezes. There were two main reasons for this knock-on effect. First, the squeeze in the USA reduced the global supply of capital. Foreign victims of the credit crunch included Britainâ€™s Virgin Money (ex-Northern Rock Bank), which ultimately required government support to survive, and Belgiumâ€™s Fortis bank, which was taken over by Franceâ€™s BNP-Paribas. Secondly, with US lenders having often repackaged their outstanding mortgage loans and sold them on to non-American banks and fundsâ€”and with cross-border bank credit to non-banks having risen more than twice as fast as domestic lending during the boom years of the early 2000s (Economist 2012)â€”investors worldwide recorded losses as the value of these assets plummeted. This caused further concern about the viability of the worldâ€™s financial system and raised questions about the lack of a central authority capable of supervising the external effects of actions that financial institutions take in their internal markets. Ultimately, the decision was made at an April 2009 G20 meeting in London to empower Baselâ€™s Bank for International Settlements (BIS) to convince banks to increase their equity capital (in absolute terms and as a ratio of their outstanding loans), in the hope that this would stabilize the global financial system. Although the implementation of these ratios would be supervised by national authorities, the fact that they were specified by an international financial institution indicated the growing sense that the solution to the crisis would only be found in global re-regulation.
The 2011â€“2012 financial crisis, on the other hand, started in Europe. Several Eurozone governments, most notably Portugal, Ireland, Italy, Greece, and Spain, struggled to reimburse debt accumulated after years of low tax revenues and high public spending (aggravated by the huge sums spent bailing out banks following the 2008 crisis). The spectre of government default was particularly frightening given that â€˜sovereignâ€™ Eurozone debt had previously been classified as a virtually risk-free asset category, with many European banks having invested heavily in reputedly safe government bonds. These institutions stood to lose substantial sums if their holdings were written off, leading to serious concerns about their long-term survival. Like the 2008 crisis, the first consequence was the growing unwillingness by banks with surplus funds to lend to normal counterparts, a renewed credit crunch that aggravated the economic recession by reducing the amount of capital available to non-financial companies. The subsequent recession meant lower fiscal revenues for Eurozone governments, creating a vicious cycle of rising debt slowing down economic activity and leading to further debt. Instead of enabling business, once again the financial markets were becoming an obstacle to growth.
With encouragement from Washington, Beijing, and Tokyo, the EU member states met on numerous occasions over 2011 and 2012 to seek a solution. The agreement they reached reflected the global nature of the crisis, largely attributed to the fact that the fiscal policies being pursued in some Eurozone countries were much less disciplined than in others (like Germany). The idea was advanced that the euro could only survive if the management of member statesâ€™ domestic budgets converged, thus if a global body (like the EU) assumed a greater role in coordinating national actions. This was similar to some of the conclusions reached following the 2008 subprime crisis. It confirmed the growing sense that the best response to global problems is to adopt global solutions.